Surplus distribution: what should Trustees consider?

Trustees’ decisions on how surplus will be distributed can often be high profile and emotive. Members may often view surplus as belonging to them and in those cases, where Trustees do not use surplus to increase member benefits, the risk of claims arising is high. Members can easily complain to the Pensions Ombudsman (PO) about the Trustees’ decision and can also make representations to The Pensions Regulator (TPR), if they consider the statutory requirements for returning surplus to the employer are not met.

This is particularly relevant if the Trustee has the unilateral power under the trust deed and rules to decide how to apply surplus. In cases where surplus may only be used to augment benefits with the consent of the Principal Employer, the Trustees’ options are likely to be constrained where the Principal Employer does not consent.

The right approach

Trustees should aim to bullet proof their decision-making process to mitigate the risk of successful member claims. This process can be complex as legislation does not provide any guidance for Trustees when faced with surplus distribution decisions.

As a starting point, Trustees must ensure that they are acting within the confines of their scheme’s trust deed and rules. Where Trustees act outside the scope of their powers, the Courts may find that the distribution of surplus is invalid and could, for example, order that the Trustees reconsider the use of surplus within the scope of their powers, or order that surplus should be used in a particular way, including that it be returned to the sponsor. Conversely, if Trustees act within their powers, and have “taken into account relevant and proper factors in reaching a decision, it is not open to the PO or any judge to interfere with the exercise of the Trustee powers” (Edge v Pensions Ombudsman).

Although there is no one size fits all approach to how Trustees should deal with surplus, a common theme that runs throughout case law is the need for Trustees to show that they have considered all relevant factors. In general, it is important for Trustees to approach the decision methodically and document the factors considered in making the decision to distribute surplus.

Entrust Pension Ltd v Prospect Hospice Ltd sums up the approach Trustees should be taking when distributing surplus. In a nutshell, Trustees must:

• give “genuine and responsible consideration” to the exercise of the power;

• exercise the power for the purpose for which it is given; and

• give proper consideration to the matters which are relevant and excluding from consideration those which are irrelevant. In this respect, Trustees should make proper enquiries to inform themselves about the matters which are relevant to the exercise of the discretion.

Factors to consider

Using case law (Thrells v Lomas) as a guide we have distilled some of the key factors we think Trustees need to consider when distributing surplus. These factors include:

• Source of surplus: Trustees should consider the proportion of member and employer contributions over time. Nowadays, employers must fund scheme deficits and surplus could be viewed as a product of overfunding which could make returning the surplus to the Employer a reasonable decision for the Trustee to take. However, it is important to note that Courts may be reluctant to conclude that an employer owns the surplus simply due to complying with funding obligations.

• Members’ reasonable expectations: In particular what has been said to Members about discretionary benefits, and whether such statements may have created a reasonable expectation for Members that surplus will be applied for their benefit.

• Size of surplus: This could involve looking at the size of the surplus relative to the cost of securing all benefits in full with an insurer. Relevant to this will be the question of residual risks and whether any of these may fall back on the employer where they are not otherwise insured. Costs relating to the winding up of the scheme will also need to be taken into account, including the cost of any runoff and missing beneficiary insurance.

• Employers’ financial position: Trustees could consider whether the employer has overfunded the scheme, and how this has impacted the employer’s financial position.

• Members’ needs: In a high inflationary environment, Trustees may want to consider the impact of inflation on members whose benefits are not fully protected (e.g. for members whose pension increases are subject to caps or who do not benefit from any increases). However, this would not be relevant if it had already been addressed as part of the buy-out, or if the Trustees did not have the power to use surplus in this way, which will depend on the scheme’s trust deed and rules.

• Historical funding patterns: Trustees need to be informed about historic funding arrangements which includes looking into whether there have been any historic contribution holidays or agreements to move towards a more prudent funding basis to e.g. accelerate de-risking.

Trustees may also need to treat different categories of member separately, e.g. members with different increases to pensions in payment, different rates of revaluation, or different contribution rates.

Of course, not all of these factors will be relevant to all schemes and therefore Trustees will need to identify which factors are relevant, having regard to the scheme’s particular circumstances, and then determine how much weight should be given to each factor.